“THE UPSIDE DOWN” of the world of finance

I recently saw this thrilling and exhilarating show on Netflix –“Stranger Things”, a sci-fi/horror murder mystery and government conspiracy set in the 1980’s with a few nerdy kids as heroes, fighting the supernatural forces.Out of the many mysteries to be solved onthis showthe most intriguing and pressing is the story world calledThe “Upside Down”– the alternate dimension threatening the future and the well-being of every character on the show. The show establishes that ifThe Upside Downpenetrates into the human world, it would be fatal for all human, plant and animal life!!

As I was wondering how the mystery of the Upside Down would unveil on the show, I began thinking of the possibilities of an Upside Downor an alternate dimension in the real world that we live in. That reminded me of the world of “Negative Interest Rates” (henceforth, NIR)where approximately 500 million people in a quarter of the world’s economies are living!Before I bring to you the mysteries of this non fictional alternate dimension, here are answers to some questions that may have come to your mind:

• Why should the NIR be regarded as an Upside Down world? What makes them different?

The general law of finance is that if you lend your money or deposit your money in a bank account for a longer period, you should be compensated for it in the form of interest or a higher return. NIR defies this rule as now you will actually be paying the bank to keep your money with them! The time value of money has in fact disappeared!
To give you an example, The German government has issued 10 year bonds that have an interest rate of –0.2%. This means – as an investor in these bonds you are actually paying the German government, 2 euros for every 1,000 euros it borrows from you, for the privilege it gives you of buying its benchmark bonds! Seems counterintuitive, isn’t it?

• Does the Upside Down world of NIR refer to “Real Interest rate” or the “Nominal Interest” Rates?

1. We are all familiar with the “Nominal Interest Rate”, which is the rate of interest on savings and loan products. For Example, Fixed Deposit giving a return of 7% p.a
2. Real Interest Rate = Nominal Interest Rate – Inflation. Continuing the previous example, if we assume inflation at 4% p.a, the real interest earned on the Fixed Deposit is only 3% p.a

At this juncture, it is important to understand that real interest rates can very well be negative when inflation is higher than the nominal interest rates, as has been the case with many economies at different points in time. But, the Upside Downis when the “Nominal Interest Rates” are negative. For Example, your Fixed Deposit Account charging you a -0.4% instead of paying you an interest of 7% p.a.

• Why was there a need for NIR in the first place?

After the Global Financial Crisis of (2007-2009), a large number of advanced economies have been stuck with low growth and low levels of investment and inflation. In order to restore growth, central banks of these economies have taken a lot of forceful monetary measures – one of the most controversial measures remains the introduction of negative interest rates as interest rates of as low as zero too failed to spur economic activity.

• What is the current situation like in the world of NIR?

Here’s what the current Central Bank policy rates look like:

It must be noted that the above are Central Bank set rates, whereas the short term and long term market interest rates, take their own path. To bring this in perspective, while the Central Bank rate of ECB is 0%, the yields of the 10 Year Government bonds of many Eurozone economies like France, Germany etc. are negative.

Some numbers on current negative yielding debt:

• The universe of negative-yielding bonds totalled $15 trillion in August 2019. It has crossed this mark for the first time.
• Majority of the portion of this negative yielding debt comes from Japan and the Eurozone.
• Some 40% of global bonds are now yielding less than 1%.
• These low rates are not just limited to sovereign bonds, 24% of highly rated corporate bonds have negative yields.(Data Source: Bloomberg)

A snapshot of key interest rates across the world:

• How are the NIR designed to work?

NIR are transmitted to the broader markets, theoretically, in the following manner:

For Example, A Danish Bank has launched the world’s first negative interest rate mortgage with the interest charge is –0.5% a year! Which means that the bank will pay the borrower for allowing the bank to get the money off its hands! However, in practise this would not have the bank paying the borrower in cash, but with every repayment that the borrowers make, the amount still outstanding will be reduced by more than the amount repaid.

• Why would anyone want to buy a negative yielding bond, in the first place?

The main reason is that the Government bond is safe. The only catch is that now, instead of a guarantee of a minimum return it now guarantees a minimum loss.
For example, let us consider the Swiss government bond  that costs CHF 103, pays no interest and will return just CHF 100 when it “matures” in June 2029. The holder knows they’ll lose only 0.3% over a decade. A term deposit in a Swiss bank would be no better, with interest rates of about -0.3%, and less safe. Buying shares or gold might return more, but carry a bigger risk of losing a lot more.

Have the NIR succeeded in achieving what they were designed to?

Let’s take a look at the economies having the biggest share in the world of Negative Interest Rates.

• Japan:The intention of the Bank of Japan is to try to lift the consumer prices, which have been sliding for majority of the past 20 years. Falling consumer prices hurt corporate revenues, keeping companies from raising wages or spending on new projects.

Have the consumer prices gotten any better?Have people started borrowing more with the money becoming cheap?

As can be seen, not much has been achieved in terms of consumer price increase or loan growth as businesses were unable to find profitable uses of their funds, even as the money became cheap.

• Eurozone: In order to revive the European economies, the ECB in 2014 took the extraordinary decision to lower one of its key interest rates to below zero.

Negative rates help to push down the cost of borrowing, but has not uplifted the euro area.

• Switzerland:What makes Switzerland’s case peculiar is that unlike Japan and the Eurozone, Switzerland had primarily introduced negative interest rates to prevent its currency to appreciate. The Eurozone crisis in 2012, has made Switzerland a “safe haven” for investors due to its strong economic history and long tradition of secure banking, causing its currency to rise sharply. It being an export economy, a strong currency would make its exports uncompetitive and hence negative interest rates were introduced to discourage foreign investments.

Despite the persistent negative interest rates, the Swiss franc’s exchange rate remains elevated. But its export trade did not noticeably suffer.

• What are the main reasons why the NIR have not been very effective?

• While NIR are designed with an assumption that commercial banks will pass on the NIR to its customers, in practise if the banks make their customers pay to hold their money, they will withdraw their cash and put it into safes (getting zero interest would be better than paying a fee on deposits) and thus would take away a crucial source of funding for banks or may even trigger a bank run. Hence majority of these banks charge negative rates only to large or institutional accounts for whom storing cash would be more expensive. These exemptions reduce the effectiveness of the NIR policy.
• Cheap credit is of little use for people without jobs. Unemployment rates are in double digits in Italy, Spain and Greece and nearly 9% in France. The under-25 jobless rate is 16% in the eurozone, damaging finances for a key spending demographic.
• Big investors such as insurance companies and pension funds cannot heavily invest in instruments such as infrastructure and loan products that would tend to spur capital spending, create jobs and help economic growth, without setting aside more money for regulatory requirements.
• Lower rates don’t address the real economic problems of weak consumer demand and weak business investment. Companies are less likely to borrow for new investments when demand for their goods and services is not increasing — even if the cost of borrowing is cheaper than ever.
• Central banks have failed to incorporate three problems: that interest rates do not always follow the central bank lead, that risk premiums on equity and debt may increase as rates go down and that exchange rate effects are muted by other central banks acting at the same time.

• Who are the ones benefitting from the NIR regime?

• Debt Laden Economies: Negative rates along with central-bank purchases of bonds to inject money into economies, depressed government bond yields through Europe, keep Italy and other fragile euro members from crumbling under high debt loads while reducing borrowing costs for businesses.

• Export Economies:Negative Interest rates have helped keep exchange rates low which make a country’s goods and services relatively inexpensive and thus more attractive for other countries to buy. That helps export economies such as Germany and Switzerland. As we saw earlier, Swiss franc is still strong, but economists think it would have been stronger without subzero rates.
• Businesses are able to borrow at cheap rates. For example, in Germany, a company secured financing under 2% on a 20- year fixed rate mortgage to build a factory!

• Who are the biggest losers? What are the harmful effects of NIR?

While central banks imposed negative rates mainly with the aim of forcing banks to lend more plentifully and cheaply in order to boost growth, the unintended consequences of sub-zero rates are eclipsing the supposed benefits.

• While banks choose to not pass on negative interest rates to their retail customers and take a hit on their profit margins and offset the same with higher values of their securities holdings, higher non-interest income, expanding lending volumes and lower loan losses, these gains shall fade away in the long run and will require banks to alter their business models.

For example, a report, which analyses the ECB data shows charges having a considerable impact on banks’ profitability, equating to a 4% decline in profits in 2018. German banks again bore the heaviest burden among major economies, losing 9% of profits.

• The desire to generate better returns could lead banks, insurance companies and other investors to lower the average credit quality of their portfolios, which means that the savings of the public could be in danger.
• As investors move to other asset classes in search for higher yields, it has led to real estate, stocks etc to become fundamentally overvalued leading to creation of asset bubbles.
• Investors may be tempted to make investments overseas driving up the price of stocks and bonds in the United States and Asia and creating bubbles that expose the global financial system and economy to another crisis.

• Ideas that have come up in recent times to make NIR work better:

The most critical challenge to the negative interest rate policy is the risk of a bank run i.e people running to banks to withdraw their cash. A lot of economists and researchers have come up with ways in which this risk can be avoided. These include tax on holding cash, randomly declaring certain bank notes void and phasing out cash altogether amongst others.

International Monetary Fund (IMF) economists have recently floated the prospect of central banks creating two separate currencies – e-money and cash – as a way to enable the negative interest rates that will likely be needed to combat future recessions.

E-money would pay the policy rate of interest (i.e negative interest rate) and cash would have an exchange rate against e-money which would depreciate at the same rate as the negative interest rate on E- money.

To briefly illustrate how the system will work:

At the same time, shops would start advertising prices in e-money and cash separately, just as shops in some small open economies already advertise prices both in domestic and in bordering foreign currencies. Cash would thereby be losing value both in terms of goods and in terms of e-money, and there would be no benefit to holding cash relative to bank deposits.
However, the implementation of dual currency system would have to be accompanied by certain changes in legal and regulatory policies and would require a lot of communication effort.

• Some mysteries of the world of NIR, that I have not been able to find answers to:

• If zero is not the lower bound for interest rates, what is the maximum the negative that the interest rates can go before investors start pulling out cash from banks and storing it under their mattresses? Switzerland had gone the lowest by charging -0.75% on excess reserves of commercial banks.· How will the financial world deal with the distortions that negative interest rates bring to analysing business models?

For example, Would companies having debtors delaying their payments, be considered better off than those whose getting their cash flows on time? · Will the next recession cycle have more economies like the U.S also being exposed to the world of NIR?

The benchmark borrowing cost in the U.S for example is at 2.5% and it has been historically seen that a rate cut of 4-5% is made in response to a recession. The Fed clearly has no room to do so in the next round of recession without letting the rates go negative!

• Will these economies ever be able to come out of the deep waters of the world of NIR or will they continue to remain drowned?

Probably, the famous Charlie Munger is right when he says “If you are not confused by negative interest rates, you did not think about it correctly”. So, I’d rather watch the next episode of Netflix’s – Stranger Thingsand see the mystery of the Upside Downunfold, while the Central Banks of these economies continue to either solve or add to the mysteries of the world of NIR.